Monetary policy

The monetary policy stance of the reserve bank continued to be the provision of adequate liquidity to meet credit growth. Support investment demand in the economy while continuing a vigil on movement in the price level.

Liquidity management in India is a subject that is not widely discounted  but is the bread and butter of daily monetary management.

Conduct of monetary policy and management in the context of large and volatile capital flows has proved to be difficult for many countries.

The evolving policy mix involved careful calibration that book into account diverse objective of central banking changes in the monetary policy framework and operating procedures and widening of the set of instrument for liquidity management.

Liquidity management and management of capital flows

While in the macroeconomics context, liquidity management refers to overall monetary, conditions, reflecting the extent of mismatch between demand and supply of overall monetary resources.

For central bank, the concept of liquidity management typically refers to the framework and set of instruments that the central bank follows insuring the amount policy.

What is the price of bank reserves?

The price of bank reserve is fixed in terms of short-term interest rate. This is set in terms of overnight inter-bank borrowing and lending rates either secured or unsecured which affect the reserves do not clear offer an their own the central bank itself steps in by influencing the short-term repurchase obligation with banks.

Supply of monetary base depends on.

1) The public demand for currency as determined by the size of monetary transactions and the opportunity cost of holding money.

2) The banking system ‘s need for reserve to settle or discharge payment obligation control banks also attempt to contract and varying the supply of bank reserve to settle meet its are therefore influenced through reserve requirements or open market operation.

Role of central bank

1) The importance of central bank liquidity management lies in its ability to exercise considerable influence and control over short-term interest rate by small money market operation.

2) Central bank typically aim at a target overnight interest rate which at as a powerful economy wide signal.

3) The liquidity management function of a central bank involves a larger economy-wide perspective.

4) Central bank liquidity management has short-term effects in financial market.

5) Central bank attempt to influence money market liquidity in order to exercise control over the short-term interest rate.

6) The central bank may directly set at one of the short term interest rate that acts as its policy rate.

Money market instrument

1)  Repo rate– Repo is a collateralized short term borrowing and lending through sale/purchase operation in debt instrument. It is a temporary sale of debt. Transfer of ownership of the securities that is the assignment of voting and financial rights. The term of the contract is in terms of a repo rate, representing the money market borrowing lending rate. Repos are usually of 1-14 days .

The collateral security in the form of SGL is transferred from  the seller to the buyer. Generally ,repos transaction take place in market lots of Rs. 5 core. Repo transaction have very low credit risk due to the SGL mechanism and the existence of collateral in the form of the underlying security.

2) Reverse repo rate– A reverse repo ready forward repurchase (buy back) is a transaction in which two parties agree to sell and repurchase the same security. The seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price.

Likewise, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date and at a predetermined price.

Reverse repo are used to

1) Meet a shortfall in the cash position

2)  Increase return on fund held

3) Borrow securities to meet regulatory (SLR) requirements

4) By the RBI adjust liquidity in the financial system under the LAF

3) Statutory Liquidity Ratio(SLR)– While the CRR enables the RBI to impose primary reserve requirements. The SLR enables it to impose secondary and supplementary reserve requirements on the banking system.

The  objective of the SLR are three-fold i) To restrict the expansion of bank credit.ii) To augment a bank’s investment in Government securities and iii) To ensure solvency of banks.

The SLR is the ratio of cash in hand (excluding CRR) balances in current account with banks and RBI gold and unencumbered approved securities to the total demand and time liabilities of the banks. The SLR defaults result in restrictions on the access of refinance.

An increase in the SLR does not, however, restrain total expenditure in the economy it would restrict only private sector expenditure but it would also help increase the government sector expenditure. A decrease in the SLR would have the opposite effect. SLR is not a technique of monetary control it only distributes bank reserve in favour of the Government public sector.

4) Bank rate– The bank rate is the standard rate at which the RBI buys rediscounts Bill’s of exchange other eligible commercial paper.It is also the rate that the RBI charges on advances on specified collaterals to banks. An increase in the B/R would decrease /increase in the lending rate of banks.Thus the B/R technique regulate the cost/availability of finance and to that extent, the volume of funds available to banks and financial institutions.

5) Cash Reserve Ratio– The CRR refers to the cash which banks have to maintain with the RBI as a percentage of their demand and time liabilities. The objective is to ensure the safety and liquidity of bank deposits.The RBI is empowered to impose penal interest on banks in respect of their shortfall in the prescribed CRR.

The penal interest is a specified percentage above the bank rate.RBI can disallow fresh access to its refinance facility to defaulting banks and charge additional interest over and above the basic refinance rate on any accommodation availed of and which is equal to the shortfall in the CRR.

The RBI pays interest equal to the bank rate on all eligible cash balances. The CRR, as an instrument of monetary policy has been very actively used by the RBI recently in the downward direction. It is at its lowest level now.

6) Open market operation(OMOs)– The OMOs refer to the sale and purchase of securities of the central and state Government and treasury-bills (T-bills). The multiple objective of OMOs, i) To control the amount of and changes in bank credit and money supply through controlling the reserve base of banks.(ii) To make the bank rate policy more effective (iii) To maintain stability in the Government securities T-bills market(iv) To support the Government’s borrowing programme (v)To smoothen the seasonal flow of funds in the bank credit market.

Through the OMOs, the RBI can affect the reserve position of banks,yields on Government securities T-bills the volume and cost of credit.

In spite of the wide power to the RBI,the OMOs is not a widely-used technique of monetary control in India. There is no restriction on the quantity maturity of the Government securities which the RBI can buy/sell/hold.

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